Profit and cash measure different things
Your profit and loss account records income when you earn it and costs when you incur them, whether or not any money has moved. Your bank balance records money when it actually moves. Over a year the two tend to meet. Over a month or a quarter they can be far apart, and bills are paid from the bank balance, not from profit.
So a business can report a healthy profit and still be unable to pay its suppliers, its staff or HMRC on time. That is not an accounting error. It is a timing gap, and it can be forecast.
A worked example
A design studio starts the quarter with £20,000 in the bank. In the quarter it invoices £60,000 of work on 60-day terms, pays £45,000 in running costs and buys £12,000 of equipment. On paper it made £14,000.
| Profit and loss | Cash | |
|---|---|---|
| Sales invoiced in the quarter | £60,000 | |
| Paid by clients in the quarter (last quarter's invoices) | £35,000 | |
| Salaries, rent and suppliers | −£45,000 | −£45,000 |
| Equipment bought outright (counted as depreciation, £1,000 a quarter) | −£1,000 | −£12,000 |
| VAT paid for the previous quarter | −£9,000 | |
| Result for the quarter | £14,000 profit | −£31,000 cash |
The studio was profitable, yet the bank balance fell from £20,000 to −£11,000 at the end of the quarter. Clients paying for this quarter's work will only pay next quarter. The equipment cost £12,000 in cash on the day it was bought, but only £1,000 of it counts against this quarter's profit. The VAT relates to an earlier quarter and does not appear in profit at all, because VAT collected was never the studio's income.
The usual causes
- Clients pay later than costs fall due. Salaries and rent are paid monthly; invoices are paid 30, 60 or more days later. Growth makes this worse, because each month's larger costs come before last month's larger sales are paid. See payment terms and cash flow.
- Tax is paid in lumps. VAT, PAYE and corporation tax are paid on fixed dates, often months after the income that created them. See VAT and cash flow.
- Spending that is not a cost yet. Equipment, vehicles and stock leave the bank at once but reach the profit and loss account slowly, through depreciation or as the stock is sold.
- Loan repayments. Repaying the loan itself is not a cost in the profit and loss account (only the interest is), but it leaves the bank every month.
- Money taken out of the business. Dividends and drawings reduce cash but not profit.
What to do about it
- Forecast cash, not profit. A week-by-week forecast of money in and money out shows the low points before they arrive. Start with the 13-week cash flow forecast template.
- Get paid sooner. Shorter terms for new clients, deposits on large jobs, staged invoicing and a steady chasing routine. See how to chase late payments.
- Put tax aside as you earn it. A separate account for VAT and corporation tax turns a lump into a monthly transfer.
- Time large purchases. Buy equipment in a week the forecast shows headroom, or spread the cost with finance if the forecast shows it cannot be paid outright.
- Keep a buffer. A minimum balance you plan never to go below gives time to act. See how much cash buffer you need.
- Arrange finance before you need it. Lenders are easier to talk to with a forecast that shows the gap is temporary and when it closes.
Where Cadence fits
Cadence builds the cash view from your invoices and bills, moves each invoice to the date the client usually pays, and adds tax, payroll and recurring costs on their real dates. It shows the weeks where cash falls below your buffer, so a profitable quarter does not hide a cash shortfall. You can try it free for 14 days.
This guide is general information, not financial or tax advice. The figures are illustrative.